For a nominally communist country, the planned sell-off of part of its two largest regional airlines, China Eastern and China Southern, to foreign investors is unprecedented. But the considerable obstacles could yet alter these plans and, even if they proceed, questions abound over whether any overseas airlines are likely to invest and if so which they will be. Air China, next on the list for privatisation, is awaiting the outcome of its regional rivals' sell-offs with interest.
Early last year China's Securities Regulatory Commission approved applications by 22 state-owned firms to offer and list shares on overseas stock exchanges. China Southern and China Eastern Airlines, already nominated by the Civil Aviation Administration of China (CAAC) as test cases for China's airlines, were among that group of 22. The two airlines picked Goldman Sachs and Morgan Stanley as their respective underwriters, with a target for initial public offerings (IPOs) and listings on the New York Stock Exchange by the end of 1994.
They missed that deadline because of the market's downturn, the poor reception received by other Chinese IPOs, and longer than expected preparations. Yet both airlines still plan to proceed. The basic reason is to help China implement an Open Door policy that had its tentative beginnings 16 years ago and reflects more than simple political theory. China needs some $55 trillion to become fully developed, already ranks second only to the US among global recipients of foreign investment, and can only go so far on debt financing and joint venture capital.
Meanwhile China's airlines have a healthy appetite for cash. In the next 15 years they expect to buy 1,200 new aircraft worth over $90 billion. As test cases, China Southern and China Eastern are 'the best of the batch' says Zayong Koo, vice president for research with CS First Boston Pacific.
Guangzhou-based China Southern reportedly had the highest 1994 operating revenue of any Chinese airline - although it will not divulge figures because of its planned offering. In 1993 the carrier reported a net profit of $95.2 million on revenues of $580 million. Shanghai-based China Eastern has reported the highest profit among Chinese carriers for the past several years - including $114.6 million on revenues of $710.9 million for 1993. With only four Chinese airlines - Air China, China Southern, China Eastern, and Shanghai Airlines - showing provisional profits in 1994, it doubtless earned that title again last year with an after-tax profit of some $82 million.
Neither China Southern nor China Eastern are particularly strapped for cash. Typically, they finance about 20 per cent of their fleet acquisitions from earnings. Their financing needs for new aircraft over the next several years are fairly modest (see chart) and neither carrier has experienced any problem raising funds at reasonable rates. Still, adding some equity to their debt can only help their balance sheets.
The CAAC sees the advantages of partial privatisation less in terms of new capital than in management reforms. Ms He Zhen, CAAC deputy director for planning, told a recent tourism and travel conference that foreign stock sales will provide a new source of finance, 'but more importantly, will cause changes in management, operation and accounting systems of state-owned airlines.'
Clearly the airlines are not the only beneficiaries of this exercise. Reliance on sovereign Bank of China guarantees, already under pressure, will diminish in two ways: from the direct financing of aircraft through new equity rather than debt, and from the greater likelihood that financiers will make asset-based loans, instead of relying on bank guarantees, to those airlines which survive the rigours of New York's disclosure and accounting rules.
The decision to list in New York was a policy judgment by China's Securities Regulatory Commission, which decides which offerings should go where. To date, 10 Chinese firms have been listed in New York, compared to 20 in Hong Kong. The only other exchange with a Chinese listing is Singapore, and it only carries one.
Hong Kong investors know more about China than their Wall Street counterparts, but Hong Kong's fixed price system on IPOs makes it less attractive for blue chip firms seeking the highest multiples on price-earnings ratios. Hong Kong shares usually generate multiples of 12 to 15, compared to New York's 15 to 20.
Ironically, New York's other attraction is the toughness of its standards. Any firm that can satisfy both the US Securities & Exchange Commission and the New York Stock Exchange obviously deserves respect: only 10 foreign airlines have New York listings. The worldwide prestige associated with such a listing may be the main reason China Southern and China Eastern have opted for Wall Street.
However in mid February, at the height of tensions between the US and China over intellectual property rights, a China Southern spokesman warned that in view of the imminent Sino-US trade war, his airline was reconsidering its IPO and listing in New York as well as its plans to buy more Boeing 777s and 737s.
The statement was certainly orchestrated to influence negotiations and illustrates the potential for havoc arising from wider trade issues. Only days before, China's State Council announced it was about to sign a memorandum with Japan's Securities and Exchange Commission for direct listing of Chinese state-owned enterprises on the Tokyo Stock Exchange.
China Southern's director of privatisation, Zhou Shou Xin, has since reaffirmed his airline's preference for New York, but the choice will remain uncertain until shares are actually offered. From a face-saving standpoint, the decision probably becomes irrevocable once the airline files its draft registration statement with the US SEC, since that is effectively the public debut of an IPO.
The key question is timing. Is now the right time from Beijing's domestic or foreign policy viewpoints? Is the timing right in terms of the markets? Even if it is, are both airlines ready to file?
The first two questions are interrelated. Beijing is unlikely to give these carriers the green light to go ahead with the IPOs if the market is unfavourable. As a matter of national and corporate pride, neither China's Securities Regulatory Commission nor the individual airlines want a repeat of the embarrassment suffered by several Chinese power companies last year. Their New York IPOs sold well below original estimates, and prices dropped another 20 per cent after shares started trading.
That poor showing was partly due to conditions that are unique to China's power sector. Analysts say its returns are too low compared with other Asian power projects, especially in view of the foreign exchange risks caused by the limited convertibility of the Chinese yuan.
China Southern and China Eastern earn enough hard currency from overseas routes to avoid some of these concerns, but the problems run deeper. In the second half of 1994, Chinese IPOs encountered an investor mood swing against emerging economies in general and China in particular. Publicity about lawsuits, non-performing Chinese loans and bank refusals to honour guarantees ended the China euphoria by highlighting the risks inherent in an emerging country that lacks much legal infrastructure. Predictions about the imminent death of Deng Xiaoping, China's ageing leader, and the destabilising effect of an ensuing power struggle have also generated much conjecture.
Chinese IPOs are not the only victims of weak markets. Non-aviation companies in Thailand and Indonesia delayed IPOs in late January due to the downturn in Asia-Pacific stocks. Justifying the postponement, the president of the Thai company said 'any blue chip' would do the same. According to CS First Boston's Zayong Koo, 'Probably the biggest hurdle facing China Southern and China Eastern is the downturn in Asian markets, especially China.'
A China Eastern official predicted last November that the carrier would wait until 'early 1995' before offering shares. By mid-February, however, another China Eastern official was admitting that in view of the market this was 'not a suitable time.'
Yet the conditions may be improving. Veteran foreign banks did not panic over reports of China's non-performing obligations. In fact, the number of foreign-backed syndicated loans has continued to rise while spreads continue to fall, signalling a faith by the more sophisticated financiers in China's soundness. Insiders says asset valuations are more realistic this year, and more fund managers seem to think they must get a foot in the door now, regardless of risks, so they can benefit when the Chinese market matures.
Perhaps what has changed most are foreigners' perceptions of China. As one analyst told the Asian Wall Street Journal: 'What oscillates wildly is the outside world's view of China. China is moving bumpily along as it always has.'
Even if the airlines and their underwriters still view the market as cool to China issues, they must balance that against the general improvement in airline stocks. As Zayong Koo sees it, 'Timing is a question of which factor outweighs the other - the downturn in China or the upturn in airlines.'
The original plan was for China Southern to go to the market first, followed by China Eastern, followed perhaps two years later by Air China. Now, in a move perhaps designed to foster competition, China Southern and China Eastern are on the same track, and there is a show of bravado from each in response to the question of which carrier will actually end up going first.
'We will see,' says China Eastern's information officer, Huang Wenxiu, with a hint of determination. 'We are confident we will be first,' replies China Southern's privatisation director Zhou Shou Xin. His view is reinforced by Gan Yuhua, deputy chief accountant, who adds: 'We are best prepared.'
China Southern may simply be more open about describing its preparation, but the facts seem to support this boast. It has already spun off China Southern Ltd, consisting of the airline, aircraft maintenance, and catering divisions, as a separate shareholding company from the rest of the China Southern group.
China Eastern has set up an internal privatisation unit, but has not yet created a separate shareholding company. Until it does, it cannot segregate financial statements, appoint separate directors, or complete any of the other structural changes required by the US SEC or the New York Stock Exchange.
Both airlines obtained Beijing's approval of their asset valuations late last year, but China Southern has a longer track record of meeting international accounting standards, having converted its books in July 1993. China Eastern changed systems 'about a year ago' and two years ago its president Wang Li'an was conceding that China Eastern's accounting made western concepts of profit meaningless. China Eastern could face a problem meeting US requirements for two years' of financial statements conforming to GAAP, though accountants may be able to restate earlier records in an acceptable form.
Both airlines are cautious about any disclosures that may contravene US securities laws, but they interpret those strictures differently. China Southern will not divulge 1994 results; China Eastern will not discuss its offering plans.
Subject to Securities Regulatory Commission approval, China Southern plans an IPO representing about 25 per cent of equity.
Following that, the airline plans to offer shares to domestic investors, and then a private offer to employees. The whole process could take two to three years and place up to 49 per cent of China Southern's equity in the hands of foreign and Chinese investors and employees.
Beijing told China Southern to abandon earlier plans that would have started with private offerings to employees, Chinese institutions, and an auction à la Qantas to foreign airlines. No private airline offering is now planned, although 'we hope foreign airlines will be interested through the IPO,' says privatisation director Zhou.
Missing December's target means 1994 financials for both airlines must now be audited before the carriers can ask Beijing for final IPO approval. Those audits could be completed by April. China Southern might launch a route to California this summer and thereby enhance its US visibility before its IPO, but only the audit appears to stand in the carrier's way. Sources also privately predict that China Eastern will be ready 'later this year'.
With both offerings now imminent, questions arise about who is likely to buy. Foreign ownership in a Chinese airline is limited to 35 per cent of total shares and 25 per cent of voting rights. According to Lehman Brothers analyst Eisha Cheng, 'All the major airlines of the world have looked at joint ventures or equity stakes in Chinese carriers.' She predicts they nonetheless will be cautious because 'Chinese airlines are in a different culture than elsewhere, and there are many ways short of an equity stake to work together.'
Senior China Southern officials met with three major US airlines during a US visit last November, but the most likely airline investors are Singapore Airlines and Cathay Pacific. SIA disclosed its interest in a Chinese airline nearly a year ago, and even admitted with uncharacteristic candour that its board was divided over whether to invest in a larger airline or a smaller one that might adapt more readily to SIA's style. As there is nothing small about China Southern or China Eastern, Singapore Airlines will need to resolve its ambivalence soon or miss out. It might be guided by the advice of managing director Dr Cheong Choong Kong, whose view on China is: 'Anyone situated in Asia at this point in time would be extremely foolish not to recognise the opportunities.'
Cathay Pacific regards China as an exception to its general rule against airline equity stakes. 'The situation in China is different,' Peter Sutch, Cathay's chairman, has said. In view of Hong Kong's future reversion to Chinese control and the way Cathay is becoming part of Chinese aviation, 'it would be unwise of us not to look at doing that type of deal,' says Sutch. Cathay would be interested in owning shares in any of China's big three carriers, although most rumours suggest a link with China Eastern.
Yet questions remain about what strategy Cathay would be pursuing. It already enjoys an extensive China network through Dragonair. Equity stakes could effectively offer Chinese cabotage, but could also provoke a Chinese airline claim for reciprocal rights from Hong Kong after 1997. So far, the CAAC has not supported such moves, as evidenced by its intervention last year to stop China Southern's bid for Air Hong Kong. Whether Beijing would view Cathay's control of Dragonair plus a major stake in a Chinese airline as undesirable concentration remains unknown.
Cathay could become a passive investor mainly for the sake of appearances. It would be no stranger in view of the 22.5 per cent Chinese holdings in Cathay, and its own involvement in Chinese airline training, data processing, aircraft maintenance, and the Xiamen airport contract. But a Cathay investment could also simply be defensive. The airline has stressed that it has no ambition to become China's flag carrier, but it would view as a threat plans by US or European carriers for a Chinese equity alliance.
However, so far no US carrier has shown much propensity for equity stakes, and geography suggests the Europeans might be more interested in Air China, if and when it floats shares, than in carriers based in eastern or southern China.
Despite this, the prospect of a contest among potential suitors is likely as China's leading airlines prepare for the plunge into capitalism.
Despite this, the prospect of a contest among potential suitors is likely as China's leading airlines prepare for the plunge into capitalism.
Source: Airline Business
